Future directions in the regulation of Victoria

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Victoria Power Gas 2004 Stamford Plaza,
Melbourne 30 November 2004

• Future directions in the regulation of Victorias
  electricity network

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Overview

• Framework for Victorian NW regulation
• Why do we regulate NW monopolies
• Incentive regulation in practice
• TFP as an alternative approach
• The current debate on NW regulation
• Victorias electricity NW regulation
• The 2000 distribution price determination
• The experience to date
• Implications for 2006 electricity price review
• Future challenges for energy NW regulation

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• 1. The framework for Victorian energy network
  regulation

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Why we regulate infrastructure monopolies

• Monopoly often efficient structure for NW
  services but also exhibits conditions for market
  failure
• Incentives/capacity to distort resource use
• Charge more, supply less, discriminate
• Cost inefficiency in absence of competition
• Regulation seeks more efficient outcomes
• Cost, price, investment, service efficiency
• But there is also risk of regulatory failure
• Info asymmetry ? supplier can game regulator
• Impact of regulatory costs, errors, disincentives
• Objective to minimise costs of BOTH market and
  regulatory failure

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Incentive regulation as a solution

• Objective to provide incentives (rewards) for
  efficient cost/service performance
• Fixed price caps for a given period imply
• Out (under) performance increases (reduces)
  profits
• Efficiency gains carried thro to next period
• Complementary incentives for service quality
• High powered incentives ? business bears cost
  risk
• Low powered ? cost risk passed to customers
• Incentives to reveal efficient costs o/comes
  info asymmetry
• Actual costs inform subsequent price reviews

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Current approaches for determining price caps

• Building blocks method used by Aust. Regulators
• Required revenue based on forecasts of efficient
  costs
• Advantages of building blocks
• Involves periodic review of price/cost
  relationship
• Historical data/precedents now available
• BB now well understood by participants
• Incentive properties have been improved
• Criticisms/shortcomings of building blocks
• Relies on cost/revenue forecasts ? info
  asymmetry/gaming
• Uses firm-specific not industry-wide analysis
• Data intensive, intrusive, costly S.T. focus
• Tension of 5 year resets and L.T. investment
  horizon
• Are alternative (eg TFP based) approaches
  superior?

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Aust. Price cap regulation in practice

• Australian regulators (mostly) use building
  blocks method to derive x factor and tariff
  basket price control
• X factor derived from
• Maximum allowable revenue (MAR) based on
  forecasts of efficient costs of operating each
  business
• MAR RAB (WACC deprn) OPEX tax eff. C/o
• X change in current prices to deliver MAR in
  the next period
• S factor incentive is based on the gap between
  target and actual reliability performance
• Given CPI, X and S, firms prices must satisfy
  price control

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TFP as an alternative approach

• Price caps based on industry productivity index
  being considered (ESC, ACCC, URF)
• Change in prices (x factor) based on change in
  TFP index
• In principle advantages over BB method
• Mimics competitive market discipline/incentives
• Prices/incentives based on industry-wide
  performance, not firm-specific costs
• Relies on historical data/not forecasts
• Index not influenced by firms own actions
• Reduces information asymmetry/gaming problems

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TFP as an alternative approach (2)

• Transitional and operational issues with the TFP
  approach
• Historical data to compute index
• Controlling for different operating environments
• Accounting for step changes in costs (tax/policy)
• Incentives to maintain quality
• Acceptance of approach/outcomes by stakeholders
• Potential improvements using TFP index but
• Further development work on data/implementation
• ESC paper in December 2004 on TFP for Vic
  distributors
• TFP index from 1995-2003
• Backward looking comparison of BB v TFP

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Current debates on network regulation

• 10 years on regulatory approaches under
  review/criticism
• Exemplified by Parer Review, PC inquiries and
  tribunal/court appeals
• Some concerns of PC (Pt 111A/Gas Code inquiries)
• Price cap regulation being wrongly applied to
  increasingly contestable markets eg gas
  transmission
• Regulation has been too cost-based/intrusive
• Excessive focus on ST price/service gains
• Focus on reducing cost of capital has depressed
  returns
• Asymmetric truncation of returns issue
• Insufficient incentive for LT investment
• Increases risk to LT viability/dynamic
  competitive potential

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Current policy debates some observations

• Scope exists for both regulatory and market
  failure
• Regulation can cause over/under investment
• Unregulated monopolies also cause economic
  distortions
• Regulatory errors will occur but
• Are they normally distributed but right on
  average?
• Are they biased against investors or users?
• Growth of investment/competition post access
  regulation
• Has it been too little/too late or about right
• Research needed to test alternative hypotheses
• Need for reform of policy/regulatory framework
• Regulators must apply the rules
• Regulators also need to respond to the debate
  creatively

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• 2. Victorias network regulation in practice

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Victorias network regulation experience

• 2001 electricity price review first since
  privatisation
• Adopted Building Blocks approach, post-tax WACC,
  tariff basket price control
• Conservative cost assumptions/no efficiency claw
  back
• Introduced cost and service efficiency incentives
• 5 yr cost efficiency carryover/S factor, GSLs for
  service quality
• Significant Po price reductions in 2001 (9.1
  18.4) reflecting pass thro of favourable
  1995-2000 conditions
• Lower interest rates
• Unforecast demand growth
• Efficiency improvement potential
• Industry concern about profit/investment impact

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The experience to date (1)

• Revenue tracking above forecast
• Demand growth
• S-factor/efficiency carryover

All DB Revenue Forecast v Actual
M 1999
Forecast
Actual
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The experience to date (2)

• Capex opex expenditure tracking below forecast
• What is the reason?
• Excessive forecasts/regulatory gaming
• Deferral of necessary expenditure
• Efficiency improvements
• Other

Forecast (m real 1999)
Actual (m real 1999)
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The experience to date (3)

• Service standards are improving exceeding
  targets, although capex / opex below benchmark
• But is medium-term reliability at risk?

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Implications for 2006 distribution price review

• ESC to continue BB approach with enhancements
• Parallel assessment of feasibility of TFP
  approach
• Expenditure forecast assessment based on
  inference that 2001-05 costs are efficient
• Rely on incentives to achieve/reveal efficient
  costs
• Focus on reason for step change from trend
• Benchmark/engineering analysis of CAPEX proposals
• Cost/service incentives to be retained/enhanced
• Renewed focus on efficient L.T. investment for
  reliability
• Review monitoring of L.T. asset mgt plans

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2006 Distribution Price Review Process

• Distributors proposals submitted 31/10/04
• 4 distributors proposing price cuts from 3 - 6
• 1 distributor proposes increase of 8
• Network CAPEX of 2.8bproposed 2006-10
• Propose to maintain reliability at 2005 level
• Need to resolve cost of safety compliance
• Next Steps
• ESC summary paper November 2004
• ESC issues paper 13 December 2004
• Submissions due 28 January 2005
• Draft Decision May 2005
• Final Decision September 2005

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3. Future Energy Regulation Challenges
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Future energy market regulation challenges

• 10 years on, regulation under criticism/review
• Multiple regulators convergence/dialogue but
• Tribunal/court appeals of regulatory decisions
• Recent policy reviews eg Parer, PC, MCE
• Proposed refinements to policy, rules, methods
• The coverage question what should we
  regulate?
• Clarifying objectives, roles, rules and powers
• Improved regulatory processes, methods,
  accountabilities
• Rationalisation of regulatory institutions
• Creation/operation of AEMC and AER
• Clarity of roles and governance arrangements
• Relationship to ACCC
• Managing regulation/resources in transition